In his latest comments, President Obama suggested that the oil company should pay unemployment benefits to thousands of oil workers laid off during a moratorium on deep-sea drilling triggered by the spill. Oil spill: BP shares plummet 11% on Obama fears

The environmental impact is real, as are the concerns of fishermen and the tourist trade. But, as an illustration, if you take the 1,356 total dead or alive creatures collected, be they flying, swimming or crawling, oiled, not oiled or pending classification across five states and the Gulf, then BP shareholders are currently paying £36.6m per animal based on the fall in the company’s value. That has got to be an overreaction even in the hysterical world of President Barack Obama. tgrph

Once or twice a year, when we’re convinced we’re right and believe there’s massive misinformation and/or misunderstanding in the marketplace, we take the time to publish an article defending a stock we own (recent examples include Berkshire Hathaway in late November 2008, when the stock crashed and CDS spreads widened to junk levels after AIG blew up and investors panicked over Berkshire’s derivatives exposure (click here) and General Growth Properties last December and January, when Hovde Capital published three bearish reports (our rebuttals were here, here and here)).

We recently established (and disclosed publicly on CBNC; see here and here) a modest (4-5% of our funds) position in BP, and the blowback has been unlike anything we’ve encountered in our careers – and being value investors, we’ve owned a lot of unpopular stocks over the years! This blowback, combined with hysterical headlines, rumors and speculation, have not shaken our confidence, but rather reinforced it, as we love buying when there’s blood in the streets and other investors are panicking.

And panic there is: with the stock down 15.8% yesterday to close at $29.20, a 14-year low, it’s now lost more than half its value since April 20th. The CDS spreads have widened to all-time highs, seven analysts have cut their rating in the last few days alone, and well-known energy investment banker Matt Simmons said yesterday, “I don't think BP is going to last as a company for more than a matter of months.” Politicians at all levels are engaged in ever-more-heated tough-sounding rhetoric, including President Obama saying that he would fire BP’s CEO, Tony Hayward, if Hayward was his employee. Finally, while BP has said it will pay for the clean-up and direct damages to those affected by the spill, the Obama Administration is going a step further and threatening to force BP to cut its dividend and “repay the salaries of any workers laid off because of the six-month moratorium on deepwater exploratory drilling imposed by the U.S. government after the spill.”

So why on earth would we own the stock of this pariah company? And if we think it’s cheap, why don’t we wait for the dust to settle, the panic selling to stop, and for the outlook to become more clear, and then buy it when it’s safer to do so? The second question is easy: because by the time the outlook is clear, the stock will be at least 50% higher. The former is a tougher question, which we discuss at length below, but in short we own the stock for two simple reasons: 1) BP is really, really profitable (the 4th most profitable company in the world, in fact), which means it’s highly likely that it will be able to cover the clean-up costs plus all damages/fines/lawsuits; and 2) the stock is really, really cheap.

Note that in owning the stock, we are not defending the company or its CEO. BP appears to have an atrocious safety record, and it wouldn’t surprise us if regulators and the legal system determine that it cut corners on the Deepwater Horizon rig, leading to the tragedy. Compounding this, BP so far has botched both the clean-up and the public relations. We think the company should have to pay for all of the damages it has caused, plus a huge fine.

Here are the key questions about which we’re thinking. We address the first (and most important) one below and will address the others in a subsequent longer version of this article.

1) How big is the spill today and how bad could it get? How much could the clean-up cost, and what might legal liabilities be? 2) How profitable is BP? What do its balance sheet and free cash flows look like? 3) What if BP cuts its dividend? If need be, by how much and how quickly could BP cut cap ex?4) Have BP’s brand and reputation been so tarnished that its future profits will be materially and permanently impaired?5) How cheap is the stock?

The first question is the most important one. To answer it, let’s try to put the spill in context and look at precedents.

Pretty much the only good news about this spill is that the Gulf of Mexico is huge, covering 615,000 square miles and containing 660 quadrillion gallons of water (http://en.wikipedia.org/wiki/Gulf_of_Mexico). Let’s compare this to the amount of oil Deepwater Horizon has been leaking. Most estimates are in the 12,000-20,000 barrels per day range, so let’s take the high end and also assume that this continues until mid-August, meaning four months since the accident. Let’s also assume that the cap captures no oil (the latest reports are that it may be capturing most of the oil, but let’s be conservative). 20,000 barrels/day x 120 days x 42 gallons/barrel = 100.8 million gallons of oil released.

100.8 million divided by 660 quadrillion is one gallon of oil for every 6.6 billion gallons of water in the Persian Gulf. That’s the equivalent of roughly one-millionth of an ounce of oil in a typical bathtub full of water.

We’re not environmental scientists and are certainly not minimizing the severe environmental damage – we’re simply pointing out that the Gulf of Mexico (and the beaches, tourist and seafood industries, etc.) will likely recover from this disaster.

What about relevant precedents? There are many, and all of them bode well for the Gulf of Mexico (and BP).

Though almost nobody has heard of it, there was a very serious oil spill in the Gulf of Mexico in 1979, Ixtoc I (http://en.wikipedia.org/wiki/Ixtoc_I_oil_spill). Here’s an excerpt on it from a recent Newsweek article (Four Environmental Disasters Worse Than the Deepwater Horizon Spill; www.newsweek.com/2010/06/10/four-environmental-disasters-worse-than-the-deepwater-horizon-spill.html):

Ixtoc Blowout, 1979News reports on the 1979 blowout of an undersea oil well off the Gulf of Mexico seem all too familiar today. There was a failure of the “blowout preventer,” an undersea fail-safe device that is supposed to close off a gushing pipe. There were frustrated reports about the Mexican government vastly underestimating the volume of oil gushing from the seabed, much like the lowball guesses from BP in April.

Day after day for a span of 10 months, a torrent of oil rushed into the Gulf of Mexico after the initial explosion near the Yucatan Peninsula. The spill was checked only in part by a cap that was lowered over the leak to siphon off a portion of the flow. After four months an oil slick had covered about half of Texas’s 370-mile gulf shoreline, devastating tourism. Only by drilling two relief wells to connect to the initial hole, then pumping mud and concrete into the gushing pipe could Petroleos Mexicanos, or PeMex, Mexico’s national oil company, stop the leak.

“The accident does suggest that blowout prevention equipment is not designed to handle the worst emergencies,” The New York Times wrote in an April 1980 editorial after the leak was finally capped. “Could a blowout in American waters be quickly capped and cleaned up?”

By the easiest measure—volume of oil spilled—PeMex’s Ixtoc I oil well was far worse than the Deepwater Horizon well: 140 million gallons of oil poured out of the Mexican well, compared to the estimated 94.2 million gallons that could escape from the well near Louisiana by mid-August, when a relief well is expected to be complete. (The worst oil spill in history occurred in 1991, when the Iraqi army ripped apart Kuwait’s oil infrastructure and released more than 252 million gallons during the Persian Gulf War. The Exxon Valdez crash in 1989 released 10.9 million gallons.)

Also, consider the Gulf War oil spill (http://en.wikipedia.org/wiki/Gulf_War_oil_spill), where roughly 10 times the amount of oil released in the Gulf of Mexico so far was released into a much smaller body of water (the Persian Gulf is less than 1/6th the size of the Gulf of Mexico by surface area and has an average depth of only 160 feet and a maximum depth of a mere 300 feet vs. a maximum depth in the Gulf of Mexico of 14,383 feet). There is some dispute about the long-term environmental damage, but according to an article in the NY Times (www.nytimes.com/1993/03/18/world/gulf-found-to-recover-from-war-s-oil-spill.html), “a 1993 study sponsored by UNESCO, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates and the United States found the spill did ‘little long-term damage’…About half the oil evaporated, a million barrels were recovered and 2 million to 3 million barrels washed ashore, mainly in Saudi Arabia.”

The Exxon Valdez spill is certainly another relevant precedent (http://en.wikipedia.org/wiki/Exxon_Valdez_oil_spill#Litigation_and_cleanup_costs). BP’s spill is much larger and is in a more populated, economically sensitive area, but it’s worth noting that the total cost to Exxon was only $3.5 billion (after multiple appeals courts and finally the Supreme Court knocked a $5+ billion judgment down to $507.5 million).

Outside of the energy industry, the closest analogy we believe is not tobacco, asbestos or breast implants, but rather Merck’s Vioxx case (http://en.wikipedia.org/wiki/Merck_%26_Co.#Vioxx). Based on speculation that Merck’s liability could be as high as $50 billion, the stock tanked from $45 to $26 in less than two months in late 2004. Here’s what Jim Cramer wrote (http://nymag.com/nymetro/news/bizfinance/columns/bottomline/10181/) at the time:

Please don’t read the articles that tell you that Merck will come through this whole because, after all, it’s a great American company, and great American companies always come back if you just buy and hold ’em.

Close your eyes and ears to the Merck sirens, because they don’t know what they are talking about. They are naïve. All of them. Because they don’t recognize that with the Vioxx debacle, Merck, overnight, has become the trial lawyers’ next big score, the next big bankruptable company out there. The Merck lovers don’t understand the vast powers of the mass-tort bar. They underestimate the power of the American judicial system to wipe out companies, innocent or guilty, for fatal mistakes. They don’t get that the plaintiffs have all the cards in these lawsuits and management has none. In fact, if I were the New York Stock Exchange, I would put a big skull-and-bones warning label on Merck’s stock that would say: “Warning—the security you are purchasing may end up worthless to you. All Merck stock bought after the recall of Vioxx might soon belong to those class-action plaintiffs who used Vioxx after the time when Merck knew that Vioxx may be lethal.”

So what happened to Merck? It has settled nearly all of the claims for around $5 billion, has won nearly all of the cases that reached juries (with relatively small awards in the losses), and the stock rallied to over $60 in the subsequent three years.

4) Here’s a story by Andrew Ross Sorkin on the front page of yesterday’s NYT business section on the rumors that BP might have to file for bankruptcy. As I said yesterday on CNBC, this is silly. And it is borderline negligent of Sorkin to write something as panic-inducing as this…

This outcome might seem far-fetched right now. But on Wall Street bankers have already coined a term for it: “the Texaco scenario.”

In 1987, Texaco was forced to file for Chapter 11 because it could not afford to pay a jury award worth $1 billion to Pennzoil. That award had been knocked down by a judge from a whopping $10.53 billion. (Pennzoil successfully sued Texaco for “jumping” its planned merger with Getty Oil, in part, by moving the case to local court near its headquarters. The jury awarded triple damages.)

…without mentioning that it was a strategic bankruptcy filing by Texaco and that its stock only fell by 10.6% upon the filing and within a week had recovered nearly all of this loss. Here’s an excerpt from a 1987 Time Magazine article (www.time.com/time/magazine/article/0,9171,964160,00.html):

The $10 billion legal battle royal between Texaco and Pennzoil clearly entered a new and murky phase after the country's third-ranking oil company (1986 sales: $32.6 billion) made its bombshell decision on Sunday, April 12, to file for Chapter 11 protection. Whichever side was right in the dispute, the horrendous legal tangle surrounding the two firms vastly increased -- along with the business uncertainty.

Nonetheless, as New York Bankruptcy Judge Howard Schwartzberg assumed his overseeing duties with Texaco, it seemed to many analysts that the company had suddenly gained the upper hand in the high-stakes brawl it had appeared to be losing. Said Sanford Margoshes, an oil analyst at the Shearson Lehman Bros. investment firm: "Texaco has bought time. Its prospects are not as bleak." Wall Street seemed to agree. When the New York Stock Exchange opened trading after Texaco's bankruptcy filing, the company's stock dropped from 31 7/8 to 28 1/2 a share. Then the holdings rebounded, closing last week at 31 1/4. Pennzoil shares, which had surged from 79 3/4 to 92 1/4 during the previous week, plunged by more than 15 points the day after the Chapter 11 action and closed the week at 78.

The Big Board seemed to judge that Pennzoil's combative chairman, J. Hugh Liedtke, 65, had overreached himself in the dispute.

5) This CNBC article, which says I’m either crazy or sly, has a survey and sly is willing 62-38 (not that this means anything, but I got a kick out of it):

What do you think of Whitney Tilson's decision to increase his stake in BP? * 345 responsesCrazy, way too much uncertainty.

Sly, eventually the dust will settle and shares will surge.62% http://msnbcmedia.msn.com/i/msnbc/Components/ColorBoxes/Styles/ColorboxImages%28globalonlyplease%29/dotRed.gif

6) Even with today’s 12% pop, BP’s still yielding over 10%, but there’s plenty of speculation that this will be cut. We don’t think the company needs to cut to dividend for economic reasons, but don’t really care if the company wants to throw politicians a bone (though it would screw untold thousands (millions?) of mostly UK shareholders, many of whom depend on the dividend). We certainly don’t own this for the dividend.

Amid the increasing backlash against the company, shareholders are now increasingly bracing for the possibility that BP will be forced to reduce or even cancel its dividend, a key income source for investors and savers in the U.K. Concerns are also rising about the price tag BP will ultimately face.

Politicians in the U.S. say BP should be using all its resources to stop the spill and clean up the Gulf, not rewarding shareholders.

Based on a [new] rate of 40,000 barrels per day, the stricken well could have spewed as much as 2 million barrels (84 million gallons/317 million of liters) of oil since it ruptured on April 20 -- eight times the amount that the Exxon Valdez spilled into Prince William Sound in Alaska in 1989. Under the Clean Water Act, BP and others could be exposed to fines up to $4,300 for every barrel leaked into the gulf, according to legal experts and official documents.http://www.reuters.com/article/idUSN1026525920100611

Transocean, the world's largest offshore drilling company, has invoked a 19th-century American law to limit its liability to $26.76 million, a fraction of what the plaintiffs are likely to seek. BP võiks nüüd mingi 18 saj. seaduse leida:)http://www.cnn.com/2010/US/06/11/oil.disaster.developments/

Almost Every Cleanup Worker From The 1989 Exxon Valdez Disaster Is Now Deadhttp://www.businessinsider.com/warning-to-gulf-cleanup-workers-almost-every-crew-member-from-the-1989-exxon-valdez-disaster-is-now-dead-2010-6